1. Reducing Social Security Risk at the PRA Level - Lifecycle Funds and No-Loss Strategies James Poterba, Joshua Rauh, Steven Venti, and David Wise Discussion by John Y. Campbell Pathways to a Secure Retirement Conference 08/10/2006

2. The Main Points Lifecycle strategies reduce risk with age, but this doesn’t help households that are constrained to take less risk than they would prefer Expense ratios are important because they lower returns for a given level of risk

3. Lifecycle Portfolio Choice Theory With iid returns, total risk exposure should be independent of age Human capital is a relatively safe asset whose value diminishes later in working life To compensate, younger households should aggressively take financial risk and older households should cut it back Mean reversion in stock returns strengthens this conclusion

4. How to Take Risk Given high historical stock returns and modest risk aversion, households should take plenty of risk Even in middle age they may want more risk than can be achieved by 100% equity investment PRVW argue for a static 100% equity strategy But there are alternatives: –Leverage –High beta stocks –Options

5. How to Take Risk Each of these alternatives has its problems: –Leverage is expensive for ordinary households except when they hold housing as collateral, and this distorts the asset mix –High-beta stocks appear to be overpriced, except possibly in an international context (emerging markets) –Equity index options appear to be overpriced Nonetheless they may give households some ability to improve on the PRVW 100% equity strategy

6. Overpricing of High-Beta Stocks

7. Overpricing of Equity Index Options

8. How to Enhance Return For given risk, it is important to get the best possible return PRVW rightly emphasize the importance of low expenses Other things matter too: –Diversification across asset classes (e.g. international equities, commodities) –Earning an illiquidity premium for retirement savings (e.g. private equity, timberland)

9. Harvard Policy Portfolio

10. Harvard Investment Beliefs (1) Source: HMC Capital Market Assumptions, 2004

11. Harvard Investment Beliefs (2) Source: HMC Capital Market Assumptions, 2004

12. What Is Realistic? Some ideas are feasible within existing structures: –Low expenses –Diversification Other ideas require institutional innovation: –Modest leverage could be accommodated by structuring a margin account –Illiquid assets require abandoning the assumption that 401(k) or PRA assets can be marked to market daily –This would be an important step to recapturing some of the benefits of more traditional pension plans.